ServiceNow (NOW, Financial) offers a cloud‑based platform and solutions to companies so as to focus on what matters, work that will reduce costs and lead to growth. In theory, this is a great concept, and the company's recent growth has led to strong capital gains of 32% year-to-date. Even so, the stock seems very risky at this ponit as the valuation has become rich. It is not that momentum stocks cannot move higher, but it is a matter of valuation versus business risks. There is good news to consider, such as the stellar first-quarter earnings report. Taking a more thorough analysis into consideration, however, I believe ServiceNow's stock is very overvalued, and there are major risks that are hard to ignore.
ServiceNow reported a strong first-quarter 2023 earnings report
In the first quarter of 2023, subscription revenues grew 24% year-over-year, while total revenues grew 22%. GAAP earnings per share of $0.73 beat estimates by $0.41, while revenue of $2.10 billion beat estimates by $10.67 million.
There was more good news from ServiceNow as the company raised its 2023 subscription revenue guidance and announced a program of $1.5 billion to buy back shares, which is the first time in the company's history that it has initiated a share buyback plan.
ServiceNow trades at a very steep premium
ServiceNow trades at a price-earnings ratio of 238.97 based on the closing price of $511.39 on May 22. The price-earnings ratio itself should not be the sole rationale for valuation, but the PEG ratio of 3.27, the forward enterprise-value-to-Ebitda ratio of 44.05 and the forward price-to-free-cash-flow ratio of 32.11 all appear to indicate overvaluation as well. These ratios are all higher than the industry medians. This overvaluation in and of itself is one of the biggest risks to investors of ServiceNow.
Main business risks for ServiceNow
ServiceNow is a widely used enterprise cloud platform that offers a range of services, including IT service management (ITSM), IT operations management (ITOM) and customer service management (CSM). While ServiceNow provides various benefits to organizations, there are certain business risks associated with its implementation and usage. Some of the potential risks include implementation challenges, integration issues, vendor reliance, data security and privacy, user adoption and training, among others.
Implementing ServiceNow can be complex and time-consuming, especially for organizations with diverse and complex IT environments. Poorly planned implementations can lead to delays, cost overruns and disruptions to business operations. ServiceNow often needs to integrate with existing systems and applications within an organization. Integration challenges may arise due to compatibility issues, data migration complexities, or limitations of the platform. Inadequate integration can result in data inconsistencies, process inefficiencies and difficulties in achieving the desired automation and collaboration across departments.
Organizations adopting ServiceNow become reliant on the platform and its vendor for critical business operations. This reliance creates a risk of service disruptions, increased costs, or potential lock-in if the vendor's service quality declines or if the organization wants to switch to a different platform in the future.
ServiceNow handles sensitive data, including customer information, employee records and operational data. Inadequate security measures or improper configuration can lead to data breaches, unauthorized access, or non-compliance with privacy regulations. Organizations must ensure they have robust security controls, encryption, access management and compliance measures in place. ServiceNow's capabilities are extensive, and user adoption can be a challenge. Lack of proper training and change management strategies may result in underutilization of the platform, limited user adoption and resistance to new processes, impacting the expected benefits and return on investment.
Furthermore, customers heavily rely on ServiceNow for critical IT and business services. Any outages or performance issues with the platform can disrupt operations, impact customer experience and result in financial losses. It is crucial to have appropriate service level agreements (SLAs) in place and regularly monitor performance metrics to minimize the risk of service disruptions.
Finally, ServiceNow operates on a subscription-based licensing model, and organizations must carefully manage licenses to avoid unexpected costs. Failure to monitor and control licenses effectively can lead to license non-compliance, additional fees, or unnecessary expenditures.
To mitigate these risks, organizations should undertake thorough planning and due diligence before implementing ServiceNow. They should involve key stakeholders, conduct proper risk assessments, establish clear governance frameworks, prioritize data security, provide comprehensive training and maintain ongoing monitoring and maintenance processes. Additionally, working closely with experienced consultants or ServiceNow partners can help navigate the complexities and ensure the successful adoption of the platform while minimizing risks.
My take
In 2023, investing in stocks has become very challenging as the main themes are high inflation and rising interest rates. There are concerns about the debt ceiling in the U.S. Even if these risks are somehow mitigated, investors should never neglect the valuation factor, and in this respect, I do not see ServiceNow as an attractive investment prospect at this time.
